Pay Ratio Rule: Practical Tips for Making the Best of a Bad Disclosure Day BY JOHN H. LOWELL

Introduction
I
t’s been about five years since Congress passed and
President Obama signed into law the Dodd-Frank
Wall Street Reform and Consumer Protection Act. In
response to the financial crisis that escalated in 2008,
legislators sought to put more controls on primarily the
larger financial institutions that do business in the U.S.
But, buried in this law was a little-debated provision sitting
in Section 953(b). It has become known as the ‘‘pay
ratio’’ rule.

On its surface, the pay ratio rule seems innocuous.
Filers of proxies are to disclose the ratio of the compensation
of the median-paid employee of the company to
that of the CEO. However, as many have learned, this
may be more difficult and more inflammatory than it
seems.

In early August 2015, the Securities and Exchange
Commission issued a final rule, effective for proxies for
fiscal years beginning after 2016, explaining exactly
who needs to disclose this ratio and how this is to be
done. To its credit, the SEC tried its best to satisfy the
needs of those who view this ratio as an important data
point for a company and to satisfy companies that complained
of potentially large expenditures to produce
what they view as a seemingly meaningless number.

If what you need are the technical details specific to
your company as to how these calculations are to be
done, you can find summaries all over the Internet. Securities
or executive compensation counsel will be more
than happy to help you. What you may have more difficulty
finding are explanations of how to prepare for that
2018 proxy season and what strategies your company
may employ as permitted by the final rule.

Key Elements

Before we dive into that, it’s important to review
some of the key elements of the final rule, particularly
in places where either the SEC has made changes from
the proposed rule or where it has afforded employers
certain options.

While the statute tells us that the number disclosed
shall be the compensation of the median employee
divided by that of the Principal Executive Officer
(CEO for our purposes), both the proposed and final
rules specify that it is in fact the reciprocal of that (a
positive integer is intended).

Generally, all employees of the parent company
and subsidiaries included in the consolidated financials
must be included, but:

who is an employee may be determined as of
any representative date within three months of the
end of the fiscal year;

compensation for full-time employees may be
annualized, but part-time, temporary and seasonal
workers’ pay may not be annualized;

workers from countries with privacy rules that
may preclude obtaining the necessary data may be
excluded (if you exclude one worker from a country,
you must exclude all of them); and

companies may exclude all workers from additional
countries up to a total of 5 percent of the total
company employee population. In doing so, first the
employees excluded due to privacy laws are counted.
If that gets the company to 5 percent or more, then
there are no more exclusions. If not, then additional
countries may be excluded so long as the total of privacy
exclusions and selected exclusions does not exceed
5 percent of the total number of employees of
the company.

Determination of the median-paid employee has
been simplified:

solely for purposes of determining who is the
median employee, the company may look to compensation
amounts from payroll or tax records; and

once a median employee is chosen, the company
may use the same employee as the median for
two more years so long as there have not been
changes to the company’s population or pay practices
significant enough to make that determination
unreasonable.

Companies may apply cost-of-living adjustments
to equalize pay between countries.
s Companies may add to their disclosures so long as
the additions are no more prominent than the required
disclosure.
All that gives companies some useful options, but
with options comes analysis to determine what to do
and where the data will come from.

Determine which countries the company operates
in. For those countries, determine:

whether privacy laws preclude obtaining necessary
data,

what percentage of employees is excluded due
to privacy laws, and

if less than 5 percent, are there other countries
that it would be possible and beneficial to exclude?

What will it take to get payroll or tax records from
all the countries? Alert people responsible for them in
each foreign country now as to what you will need.

Consider whether the value in using cost-of-living
adjustments outweighs the cost of doing so. For some
countries, good cost-of-living data may be very difficult
to obtain. For others, while the national cost-of-living
index may be high or low, the cost in the areas in which
your employees work may be very different.

Consider the benefits of sampling employees
rather than using the whole population. Based on the
descriptions of sampling techniques described by the
SEC in both the proposed and final rules, for most companies,
this exercise will not be worth the trouble of understanding
the sampling techniques.

Perhaps the most important decision that a company
will make regarding the pay ratio is what it chooses to
disclose. Some companies won’t have to worry about it
every year, but in some years these pay ratios are going
to be very large. Even if the company’s board of directors
feels certain that CEO compensation at their company
is reasonable, the optics will be bad.

Good consultative thinking can be very helpful here.
Let’s consider a few possible situations.

Examples

Company A – Many Seasonal Employees.

Company A (calendar-year filer) does significant
business around the holidays. In fact, its workforce is
typically about three times as large between September
15 and January 15 as it is the rest of the year. Because
of that, the median-paid employee of Company A is
likely to be a seasonal employee (recall that companies
are not permitted to annualize the compensation of seasonal
employees). Additionally, those seasonal employees
likely never meet the requirements to participate in
most of Company A’s benefit programs including its
pension plan. This pay ratio is going to be high. Company
A should consider making an additional disclosure
showing a comparison of the compensation of its
CEO to that of its median full-time employee. While this
won’t change the required number, it will improve the
optics significantly.

Company B – U.S. Pension Only.

Company B is a multinational organization with significant
employees in countries around the globe. Most
of the U.S. workforce is well-paid, making it unlikely
that the median employee will be from the U.S. Company
B has provided both a broad-based and a nonqualified
pension plan in the U.S. for many years. In
most of the countries in which it operates, providing
pensions is not the norm and doing so would make
Company B less competitive. Because the increase in
the actuarial present value of accrued pensions is part
of the calculation of ‘‘annual total compensation,’’ the
pay ratio is going to be larger than Company B might
like and its board thinks the required ratio is not representative.
Company B should consider providing a ratio
for the U.S. only and a ratio without regard to pensions
as supplemental disclosures.

Because of extraordinary performance over the period
ending Dec. 31, 2016, Company C’s executives received
much larger-than-normal cash incentive payouts
(short-term incentive) and equity grants and awards
(long-term incentive) in 2017. The pay ratio here is going
to be very high, but the board’s rationale is that the
CEO deserved it. There may be many readers of the pay
ratio who don’t agree. Perhaps they won’t look at the
reasons for the high pay ratio, but simply the number
itself.

Company C might consider a number of options.
First, there might be a narrative describing why certain
elements of compensation were as high as they were.
Second, Company C might disclose what the pay ratio
would have been had the company (and CEO) merely
met goals for the year rather than exceeding them.
Third, Company C might disclose what the pay ratio
would have been had its CEO received his average incentive
payouts for the last three years or five years.
Any or all of these will help to lend some perspective to
the otherwise high pay ratio.

Company D – Varying Global Economies.

Company D has its operations primarily in the U.S.
and in South America. It provides broad-based and nonqualified
pensions in virtually every country in which it
operates. During 2017, the economy in South America
was vastly different from that in the U.S. As a result,
while interest rates dipped in the U.S., they rose significantly
in every country in South America in which Company
D operates. This combination produced massive
increases in pension values in the U.S. (for executives
and for rank-and-file), but decreases (zero for annual
total compensation purposes) in all of South America.
Since pensions are a significant portion of actual compensation
for Company D’s South American employees,
their compensation will appear understated for 2017
while the CEO’s compensation will appear overstated.

Company D should consider several additional disclosure
options:

Disclose a ratio for its U.S. employees only,

Disclose a ratio assuming that pension discount
rates had not changed in any country, or

Disclose a ratio without regard to pensions.

Company E – Highly Diversified Global Business.

Company E is probably the most complex situation
we will face. In the last few years leading up to and including
2017, it has generated a significant part of its
revenue and most of its profits from its financial services
division, which operates mostly in the U.S. Its
CEO has to operate like the leader of a large bank and
is therefore compensated commensurate with that. But,
as a hedge against cyclical issues, Company E also operates
in a variety of other industries and in multiple
countries. The industries that are the most labor-intensive
also employ the majority of their workers in
low-paid third world countries. And, to the extent that
Company E is involved in those industries in the U.S.,
its workers are largely unionized.

Company E has considered sampling to simplify the
process. However, upon an examination of the rules,
Company E realizes that it will have to do samples of
each of its industry groupings in each country in which
it operates. While it might reduce the number of employees
that it has to evaluate, the expense of getting
through the samplings outweighs the gains.

Company E realizes that its pay ratio is going to look
very high. Philosophically, it is fine with that as its
board feels certain that it is justified. But with multiple
union contracts coming up for bargaining, Company E
also knows that the unions will use the pay ratios to
wage multiple media campaigns against Company E
and its CEO.

In its disclosures that will go along with its required
pay ratio disclosure, Company E needs to consider all of
this. Here are some of the disclosures that Company E
might make:

U.S.-only pay ratio,

Disclosure of median pay for a typical employee in
each of the U.S. unions with a breakout highlighting the
company’s large expenditure on union pensions,

Salaried-employee-only pay ratio, or

Additional pay ratio compared to the union employee’s
median pay encompassing elements not normally
included in annual total compensation such as
health care expenditure.

Each of these additional disclosures has a cost associated
with producing it. But, in Company E’s view, not
producing ratios like this may be more costly than the
hard costs to generate them.

Now What?

If you happen to be a part of one of the fortunate
companies for whom this disclosure will neither be a
calculational nor public relations problem, then your
job should be easy. If, on the other hand, your company
is closer to one of these more problematic situations,
then you might have your work cut out for you.

Chances are that most in your company will not focus
on this until after the end of fiscal year 2017. That
may be okay, or it may not. Developing some of the ratios
that we’ve discussed may be time-consuming and
data-intensive. Trying to do that at the last minute may
not be advisable.

Similarly, for a number of companies, this will be
more than a calculation. It will be a strategy. Given the
potential cost in investor relations and perhaps a battle
over say-on-pay, it might be wise to have someone independently
thinking about these issues. While using
consultants haphazardly can create problems that were
never there instead of solving them, here using a consultant
who has thought through the issues and can
help your company do the same would likely be money
well spent.

You know that your company pays both rank-and-file
and executives appropriately. Now you have to ensure
that you manage the message so that all the interested
observers know that as well.

Disclaimer

The opinions expressed in this blog are not those of anyone but the author of the particular post or comment. Nothing in it is to be construed as the opinion of any employer unless specifically disclosed as such.

The express intent of this blog is to provide no investment advice of any type. While asset allocation and theory may be discussed in a research or academic context, no advice as to specific investments or strategies is intended or permitted.